Abstract: Conventional wisdom suggests that oil price increases have a negative effect on the output of oil-importing countries. This is grounded in the experience of the US between 1940s and late 1980s where recessions are generally preceded by oil price increases. In this paper, we evaluate the impact of oil price shocks on the Philippines--– a developing country and a net oil-importing economy. Following Kilian's (2008) structural decomposition of real oil price change, we find indications that the recent oil price decline may have lowered the Philippine economy's output growth, potentially due to the economy's reliance on remittances from abroad and the export market.

- Arlan Brucal and Michael Abrigo, University of Hawaii Economic Research Organization (UHERO), East West Center, September 12, 2016.

Since the beginning of 2016, oil prices have hovered around $30 to $50 a barrel. These current prices are about a third of the 2008 peak crude oil price of $145 per barrel. The recent significant drop in oil prices are the greatest we have seen since the 1980s. Like many other price fluctuations in goods, the recent drop in oil prices have benefited some more than others. Conventional wisdom suggests that low oil prices will benefit oil consumers while oil exporters will suffer. As the case may be, the effect of low oil prices is not that simple.

On September 12, Arlan Brucal highlighted the importance of looking at the causes of recent oil price changes, and their direct and indirect effect to an economy through international trade and factor mobility. Focusing on the Philippine’s economy as a test case, Arlan finds an indication that the recent oil price drop may have slowed down the growth of the country’s gross domestic product (GDP) by 5.5 percent. This seemingly counterintuitive result is largely due to the fact that the Philippine economy is heavily reliant on service exports, a component of the national output that suffered heavily from the recent oil price drop. Demand for crude oil has not recovered from the 2014 slump, and still cripples oil-exporting economies, which host most of the overseas Filipino workers (OFWs). Over the past decade, remittances received by the Philippines from abroad account for about 15% of the country’s GDP. The share of remittances to Philippines’ total output is significantly higher than India and China – the two biggest recipients of remittances in 2014 – and much higher than world averages.

Arlan and Mike’s study employs Kilian’s (2008) vector autoregression (VAR), which decomposes oil price shocks into supply shocks, aggregate demand shocks and oil-specific demand shocks. Supply shocks are unanticipated changes in the global crude oil supply. These supply shocks could emanate from exogenous geopolitical conflicts, discovery or new resources, or technology (i.e. fracking). Aggregate demand shocks are unanticipated changes in real economic activity, which includes economic booms in China or economic recessions that reduce the demand for industrial commodities including crude oil. Oil-specific demand shocks are changes in the demand for crude oil that are not related to aggregate demand shocks. These shocks include precautionary demand shocks associated with the future oil demand-supply conditions. An example of which would be a sudden drop in the price of oil because of the looming conflict in the Persian Gulf in the early 2000s. The study finds indications that the recent drop in oil prices are driven by a combination of both aggregate demand and oil-specific demand shocks. These findings are in contrast to the popular view that cheap oil is due to an oil oversupply caused by the surge in US oil production (Figure 1).

Figure 1. Historical Decomposition of World Crude Oil Price Changes

Note: Each bar reflects the relative contribution of each estimated structural shock to oil price changes for the period 1976-2015.

Source: Brucal and Abrigo (2016)

While the results appear to be quite convincing, their external validity is yet to be established. Indonesia presents a potentially good comparison example for this study. Indonesia and the Philippines share many commonalities: multicultural/ethnic, developing countries, nations that consists of many islands, exportation of laborers to many oil producing countries, etc. Does Indonesia have a similar pattern of remittances from overseas workers in oil producing countries, and do cheap oil prices negatively affect these remittances to Indonesia like they do in the Philippines? The fact that Indonesia is an exporter of oil could make the comparison difficult, but there are recent arguments and evidence that Indonesia’s oil production is starting to decline and that it is starting to consume more oil than it is producing. While Indonesia presents one interesting case to compare the Philippines with, further research could be expanded to include a number of countries with a wide range of dependence on remittances, which might help to establish if remittances is indeed a major mechanism.

Additionally, it was pointed out that the Filipino diaspora in the US was not accounted for, or that the US-Filipino diaspora did not make up a noticeable population and source of remittance as some the other overseas Filipino populations. One would assume that the US Filipino diaspora would still be a large population. Taking into account that cheap oil prices have been associated with economic booms in the US, we could possibly hypothesize that remittances from Filipinos in the US would increase. Could this US-Filipino remittance recover the losses felt from the loss of petro-dollars and remittances from Filipinos that work in oil producing countries? This could be another aspect to consider.

The negative impacts that Arlan’s findings could have are possibly reflected in the lack of sophistication of the Philippines workforce. Continued export of unskilled laborers to oil producing countries and the reliance on their income partly being shifted back to the Philippines is potentially holding its economy back. However, if the Philippines is labor abundant and capital poor, the Philippines may be better off by exporting workers to labor deprived countries. Perhaps further development of the workforce could help decrease some of the reliance on service jobs in oil producing countries. Further education and development in human capital can certainly help. The Philippines could also encourage more foreign direct investments as well although negative impacts particularly on natural environment would have to be monitored.

Arlan and Mike’s study is part of a bigger project that studies the impact of oil price-related shocks to developing countries. Most of the current literature has focused on the more advanced economies of the world like the US. Hopefully, Arlan and Mike’s study will help fill the void in the literature on the impacts of oil prices on developing countries. Future studies building upon what Arlan and Mike have done are highly anticipated.

Trevor Fitzpatrick is a graduate student at the Department of Urban and Regional Planning (DURP) – University of Hawaii at Manoa

UHERO's Project Environment will be leading the economic analysis for a new National Science Foundation project addressing critical gaps in the understanding of Hawaii’s fresh water supply that limit decision making, planning and crisis responses. ‘Ike Wai (from the Hawaiian ‘ike, (knowledge), and wai, (water) spans geophysics, microbiology, cyberinfrastructure, data modeling, indigenous knowledge and economics and connects university scientists to state and federal agencies and community groups.

Diversity in volcano age, eruption types, structural history, and hydrological features generate a complex subsurface water system that provides most of Hawaii’s potable water supply. While many hydrological studies have been carried out in Hawaii, relatively little is known about the exact structure of the many groundwater (GW) aquifers that are present throughout the state. Existing models are able to approximate the structure, but the accuracy of predicted water flows and sustainable yields for Hawaiian watersheds is limited by the availability of existing data, which is used to calibrate the models. Accordingly, ʻIke Wai will use new technology to measure the volume and interconnectivity of aquifers within Hawaiian volcanoes. Geophysical imaging will provide new high-resolution 3D maps of geologic structures. Real-time monitoring will support analysis of aquifer volume and hydraulic conductivity estimations. Flow and aquifer connectivity measurements will integrate three approaches: submarine GW Discharge (SGD) analysis, geochemistry and the innovative use of microbial diversity as a GW tracer.

Data and outputs from ʻIke Wai will provide decision-making tools to address challenges related to water availability and sustainability. Recent research on the West Hawaii coast has shown that we do not fully understand the size, flow rates, and boundaries of our groundwater aquifers. Without a clear understanding of how much water is available, we cannot properly plan future water use and management. There is currently significant debate over whether there is enough water to meet planned development while ensuring the biological and ecological integrity of surrounding nearshore habitats. ʻIke Wai will provide crucial geophysical data that will allow us to assess how much water is available to support both humans and nearshore environments.

Once we know the size, volume, and flow rates of groundwater aquifers, we can match these water supply estimates with current and projected demands for water. These demands come in the form of human demand — for domestic, commercial, agricultural, and municipal use — as well as biological and ecological demands — for example the dependency of nearshore organisms on freshwater discharge to the ocean, which is driven by the size and flow rate of up-gradient aquifers. The research from ʻIke Wai will help resource managers, policy makers, and the general public understand how scarce groundwater is in these areas, and how these resources should be priced, pumped, and managed to achieve the objectives that will be determined as part of our stakeholder engagement process. These objectives could be related to development, ecological integrity, and/or cultural integrity — we won’t know exactly what we are aiming for until we engage the stakeholders in our research.

The ʻIke Wai Initiative will give us a better sense of where the water is, how much is there, how much and where we can pump for what uses, and how we should best manage (price, restrict, require permits for, etc.) this resource. Stakeholder engagement and policy evaluation are also key components of the project, so we believe that the research results will not only be transformative from a scientific perspective but also useful for planning and management. Providing user friendly access to data and research results is an important objective of the project. Software engineers will work collaboratively with other members of the research team and stakeholders to create web and mobile applications for data dissemination, interaction and visualization.

Innovation is the key to economic growth and prosperity. In the US, innovation-led productivity growth accounts for roughly half of all the increase in US GDP. And despite our increasingly connected global economy, innovation occurs at the regional level. While there is no shortage of reports that provide snapshots of Hawaii’s innovation ecosystem, or that catalog innovation assets at a point in time1, it is important to be able to track our progress over time and to see how Hawaii stacks up against other states and localities. After all, as they say, what gets measured gets done.

UHERO’s Hawaii Innovation Matters dashboard2 is our first attempt to provide a common set of statistics to facilitate research driven dialogue on the important topic of innovation and regional economic development. Innovation is more than scientific discovery or coming up with new ideas. It connects knowledge, assets, and networks to create both new products and new methods of creating goods and services to sustain global competitive advantage. As a result, the Hawaii Innovation dashboard covers a range of indicators suggested by the Council on Competitiveness report on Measuring Regional Innovation. Below I provide a short description of a few of the metrics we track in the areas of Education, Research & Development, Entrepreneurship, and Economic Prosperity.

Talented people are the source of innovation, and harnessing the talents of a skilled workforce is a necessary ingredient for economic growth. Hawaii Innovation Matters tracks measures of human capital ranging from secondary math and reading scores to the share of young adults with college degrees or college graduates with STEM degrees. Equally important are our investments in research and development (R&D). We track key measures of academic and business R&D, as well as outcomes in the form of patents, University startups and technology licenses.

Inputs to the innovation process must also be matched by entrepreneurial capacity and effort. New and young businesses are the primary source of net new jobs3, so we report statistics on the share of jobs in startup firms, their survival rates, and venture capital funding. Finally, the end goal of research, development and innovation is higher productivity, rising standards of living and, ultimately, increasing well-being of Hawaii’s people. Here, we assess Hawaii’s progress by comparing per capita gross domestic product for Hawaii, other states and the nation, along with key measures of labor force activity and regional price parities.

As you explore Hawaii’s performance and progress in Education, R&D, Entrepreneurship, and Economic Prosperity, I hope you will learn something new and reach out with your comments. We welcome your input and feedback as we work to track what matters for innovation.

UHERO’s Energy Planning and Policy Group has been writing about how variable pricing of electricity, both wholesale and retail, can lower the cost of intermittent renewables. Get the rates right, and facilitate easy open-access to the grid for both buyers and sellers, and amazing things can happen. The idea is that variable rates will encourage households and businesses to shift electricity demand toward intermittent supply, and facilitate creative, low-cost storage of power, all of which would enable cheaper, faster growth of renewables.

Hawaiian Electric Industries (HEI) seems to be moving in this direction. With the right incentives they might move quicker. Unfortunately, the utility has little incentive to implement variable pricing, except to please the Public Utilities Commission (PUC), since these adjustments might do for free what otherwise requires investment in batteries, new power plants and other grid upgrades. Under current regulations HEI grows its profits by maximizing investment, regardless of whether or not those investments are cost effective.

But here I’d like to focus on another rate that can make a big difference in the cost of renewable energy: the interest rate used to finance capital investment. It’s a good time to write about this little detail as the PUC, Consumer Advocate, legislators and others pour over HEI’s latest, more comprehensive revision of the Power Supply Improvement Plan, or PSIP. While there’s lots to study and think about here—all 1200 pages of it—the interest rate assumptions strike me as, well, high. And I wonder if these could be a key factor underlying some differences between HEI’s plan and our own Matthias Fripp’s plan. The plan also includes off-shore wind, which at a cost of about $4/Watt, may be an economic part of the portfolio—it will be good to incorporate this possibility into Fripp’s planning model.

Here’s the crux: interest rates have been trending down for the last 35 years, and sit near all time lows today. And there’s little hint in market data that they’re likely to go up much soon. Yet, in the midst of these low rates, HEI’s new PSIP uses rates that were typical for utilities some 20 years ago.

HEI’s assumed cost of capital is comprised of 57% equity, for which they claim a cost of 11%, which exceeds rates that many public utility commissions complained about as early as 2004, when market interest rates were much higher than they are today. Expectations for future rates of return on equities are smaller today than they were ten or twenty years ago, and utilities tend to have lower-than-average rates of return because they are considered safe, since returns are all-but-guaranteed by the government. Rates for debt also appear roughly 20 years old. Today, typical rates on corporate “a” bonds, a conservative rating for utility investments, are less than 3 percent on average, and barely over 4% for long-term issues. HEI assumes 7% for long-term debt, which is assumed to comprise 39% of capital costs. The return rate for equity is a policy decision, but it stands to reason that rates ought to follow market rates, which have come down 3-4 percent since 10% was typical.

Clearly, higher overall interest rates would imply higher overall generation costs and higher rates for customers. But the rate also influences the cost-effectiveness of different generation mixes. For wind and solar, nearly all costs are for up-front capital. Conversely, for traditional power generation (oil, coal, natural gas and biofuels), fuel and operation costs generally comprise a larger share of cost than generating equipment. Higher rates therefore favor traditional generation.

Another more subtle consideration is that solar and wind investments have lower risk premiums than traditional fuel-based generation. The reason is that solar and wind pay a higher dividend if fuel prices spike, which is just the opposite of traditional fuel-based generation. This means solar and wind can do more to reduce risk from the larger investment portfolios of typical equity shareholders, and should therefore have a somewhat lower cost of capital.

The upshot of all this is that the high rates used in the PSIP artificially make natural gas and biofuels more attractive from a cost perspective than solar or wind, and generally cause the projected path of customer rates to be higher than they need to be. Two or three percentage points can make a really big difference, as any homeowner with a mortgage can tell you. You can also get a sense of the magnitudes by playing with our solar calculator (now mostly obsolete due to the end of net metering).

We shouldn’t blame HEI for doing what they can to negotiate rates up, for the rate on equity, and the share of capital they finance with equity, is their main channel for growing profits. HEI has a legal obligation to its shareholders to seek to maximize profits, which the new PSIP does skillfully. It’s even better for them if higher rates causes capital investments better-suited to HEI (like developing a new traditional power plant, or retrofitting an old one) to be more attractive than those best suited to a third-party provider. And making the rate for debt similarly high may help to obscure the fact that the equity rate is so high. The problem with cost-of-capital rates falling much less than market interest rates is not unique to Hawaii, although the PSIP rates still appear higher than typical.

As I’ve argued earlier, regulatory incentives could be changed such that HEI would have an incentive to find the most inexpensive and cost-appropriate capital possible and implement variable rates. This could also help HEI align its profit-oriented goals with the state’s affordable, renewable energy goals. The trick is to divorce their profits from the size of their own capital investments, and instead link profits to improvements in overall cost efficiency of the system, including distributed energy. Other states are also flirting with different incentives for utilities. Finally, build renewable energy goals directly into the cost structure by taxing fossil fuels and/or subsidizing renewables, regardless of source. This approach is one option for a “new business model” that many vaguely refer to.

Other models could work too. I gather that many see these high rates and conclude that a government municipality or cooperative, which would have considerably lower capital costs, as the answer. But it’s important to keep in mind that these alternative structures have incentive problems too. Another option would be to replace HEI with an Independent Service Operator, or ISO. I’m still learning sbout ISOs, but think the model could hold a lot of promise for Hawaii. I’ll have more on ISOs in another post.

Today’s low interest rates, combined with remarkable technological advance in renewable energy, creates what could be an amazing opportunity for Hawaii. It’s conceivable to me that we could transition toward 100% renewable faster than many currently believe. Maybe not in Dinah Washington’s 24 little hours, but soon enough. But to do it, and do it cost effectively, means getting the rates right.

Perhaps the greatest obstacle to a renewable-energy future is that our utility, Hawaiian Electric Industries (HEI), has little or no incentive to transform its operation into a model more suited for renewable energy. While there has been a lot of hand-wringing and criticism of HEI for its monopoly and slow approval of distributed solar, it’s important to realize the truly unprecedented change they are being forced to undertake. And worse, the new cutting-edge system they are being asked to adopt will literally undermine its profits.

Revenue decoupling (PDF) was supposed to correct HEI’s incentives by ensuring that the utility could recover the same revenue toward its operation costs even if they generated less electricity due to growth of distributed solar or improvements in energy efficiency, both of which have factored into higher electricity prices.

Revenue decoupling does make HEI less vulnerable to improved efficiency and growth of renewable energy over the short run. But over the long run the utility profits mainly from making new capital investments. For such investments they receive a nearly guaranteed rate of return that far exceeds low-risk borrowing costs. If the utility is forced to retire its old power plants and instead buy renewable energy from independent providers—the apparent inclination of the Public Utilities Commission---its rate base and profitability decline. Thus, even under revenue decoupling, low-cost renewables do not accord with HEI’s interests.

The larger problem is that the regulatory infrastructure is not conducive to a rapidly changing energy landscape in need of innovative and perhaps distributed solutions. HEI has little incentive to control costs, much less increase renewable energy in a cost effective manner.

It doesn’t need to be this way. We can fix regulatory incentives. But given the novelty of the renewable energy system we are creating, combined with Hawai`i’s geographic uniqueness, it seems unlikely that we can simply borrow a regulatory model from the mainland. Some are calling for our private utility to be replaced by publicly-run municipality, or possibly a cooperative like the one on Kaua`i. These models might work. But it’s not clear how long it would take to transition to these systems, or whether they will bring about the most innovative solutions.

What’s the fix? First, the utility needs to have some skin in the game. Full cost recovery via rate adjustments—the current regulatory situation---gives the utility virtually no incentive to be strategic in its management and planning. Instead, if costs fall due to cost-effective development or contracting of renewables, the utility should get to keep a share of the gains. The utility’s profits ought to be tied to its cost effectiveness, not the size of the capital outlay. At the same time, if oil prices rise, then the utility should absorb a share of the cost increases, such that it cares about oil price volatility just as its customers do.

Second, to the extent that the state wishes to favor renewables over fossil fuels, fossil fuels should be explicitly taxed and renewables subsidized. Such incentives could be made roughly revenue neutral and would be more effective at achieving renewable energy goals in a cost-effective manner than the state’s expensive and seemingly pointless renewable energy tax credits. Federal credits are more-than-adequate to make distributed generation cost-effective to homeowners, even under revised rate structures. And we should allow utility-scale and distributed renewable energy generation to compete on equal footing. Instead of the tax credit, customers should be able to sell all surplus generation to the grid at appropriate real-time rates.

Of course, regulators will need to negotiate a baseline profit level, how the baseline will change over time, the share of overall cost changes born by the utility and passed on to customers, and whether the utility’s share of cost improvements ought to phase out over a number of years. Regardless of these choices, these kinds of changes in regulatory structure would align the utility’s interests with their customers as well as the state’s renewable energy goals.

The big, encouraging news is that the cost of reducing greenhouse gas emissions and slowing global warming now looks cheap. While Hawai`i’s contribution to this global problem is minimal, if we can show the world how to do renewable energy in a smart, cost-effective manner, we could be a true global leader in helping to solve it. But without smart policy, we’ll only serve the interests of denialists and naysayers who will point to Hawai`i’s renewable energy boondoggle as an excuse for inaction.